Increasing the flow of foreign direct investment (FDI) to developing countries is a
cornerstone of new international development commitments. Accordingly, this paper reviews
the state of knowledge regarding i) the factors that lead firms to build a plant overseas and ii) the
influence that other policies (notably foreign aid) might have on those decisions. There are two
broad motives for FDI: a “horizontal” motivation (to gain access to markets in the recipient
country) and a “vertical” one (to exploit differences in production costs at various points in the
production process). The clear message of the empirical literature (much of it focused on FDI
flows between rich countries) is that market access is quantitatively far more important than
production costs.
What are the lessons for policy coherence? Positive effects of FDI on growth depend on a
country’s absorptive capacity; aid can be used to promote human-capital accumulation while
trade policies can facilitate the export orientation of the host economy. Both of these actions
increase the likelihood of reaping rewards from FDI inflows. In particular, aid policies can aim at
improving a recipient country’s communication infrastructure and institutional capacity. These
policies attract FDI in turn, as they lower production costs and improve the prospects for
productivity gains. Finally, trade facilitation between poor countries (to enlarge the market
access represented by a given FDI destination) and temporary non-reciprocal market access
improvements granted by rich countries could help attract FDI.